Solutions to Net Present Value and Other Investment Criteria - PowerPoint

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					                           Chapter 9
        Net Present Value and Other Investment Criteria --
             THE BASICS OF CAPITAL BUDGETING
                                         Should we
                                         build this
                                         plant?




BMGT440 – Dr. E F Kiss                                       -1
                         Key Concepts and Skills

        Be able to compute payback and
         discounted payback and understand their
         shortcomings
        Understand accounting rates of return and
         their shortcomings
        Be able to compute the internal rate of
         return and understand its strengths and
         weaknesses
        Be able to compute the net present value
         and understand why it is the best decision
         criterion
BMGT440 – Dr. E F Kiss                                -2
                         Chapter Outline

        Net Present Value
        The Payback Rule
        The Discounted Payback
        The Average Accounting Return
        The Internal Rate of Return
        The Profitability Index
        Modified Rate of Return
        The Practice of Capital Budgeting


BMGT440 – Dr. E F Kiss                       -3
                 WHAT IS CAPITAL BUDGETING?

         Analysis of potential additions to fixed
          assets.
         Long-term decisions; involve large
          expenditures.
         Very important to firm’s future.
           conceptually, capital budget process is identical
            to decision process used by individuals making
            investment decisions




BMGT440 – Dr. E F Kiss                                          -4
                                  Steps:



     1. Estimate CFs (inflows & outflows).
     2. Assess riskiness of CFs (Cash Flows).
     3. Determine R = WACC (adj.).                  determine appropriate
     discount rate, based on riskiness of Cash Flows & general level int.rates

     4. Find NPV of the expected cash flows and/or IRR.
     5. Accept if NPV > 0 and/or
                IRR > WACC.

BMGT440 – Dr. E F Kiss                                                           -5
       An Example of Mutually Exclusive Projects:




                     BRIDGE VS. BOAT TO GET
                    PRODUCTS ACROSS A RIVER.
      mutually exclusive, if the cash flows of one can
      be adversely impacted by the acceptance of the
      other.
      projects are independent if CF of 1 not affected by
      acceptance of other
BMGT440 – Dr. E F Kiss                                      -6
                         Good Decision Criteria

        We need to ask ourselves the following
         questions when evaluating decision
         criteria
           § Does the decision rule adjust for the time
             value of money?
           § Does the decision rule adjust for risk?
           § Does the decision rule provide information
             on whether we are creating value for the
             firm?



BMGT440 – Dr. E F Kiss                                    -7
                         Project Example Information

        You are looking at a new project and you
         have estimated the following cash flows:
           §   Year 0:    CF = -165,000
           §   Year 1:    CF = 63,120; NI = 13,620
           §   Year 2:    CF = 70,800; NI = 3,300
           §   Year 3:    CF = 91,080; NI = 29,100
           §   Average Book Value = 72,000
        Your required return for assets of this risk
         is 12%.



BMGT440 – Dr. E F Kiss                                  -8
                         Net Present Value

        The difference between the market value of
         a project and its cost
        How much value is created from
         undertaking an investment?
           § The first step is to estimate the expected
             future cash flows.
           § The second step is to estimate the required
             return for projects of this risk level.
           § The third step is to find the present value of
             the cash flows and subtract the initial
             investment.
BMGT440 – Dr. E F Kiss                                        -9
                              NPV – Decision Rule
       If the NPV is positive, accept the project
       A positive NPV means that the project is
        expected to add value to the firm and will
        therefore increase the wealth of the owners.
       Since our goal is to increase owner wealth,
        NPV is a direct measure of how well this
        project will meet our goal.
                                n
                                       CFt
             NPV            t 0   1  R t
                                               .

                          n
                                  CFt
               NPV                       CF0 .
                         t 1   1  R t



BMGT440 – Dr. E F Kiss                                 -10
                   Computing NPV for the Project

        Using the formulas:
           § NPV = 63,120/(1.12) + 70,800/(1.12)2 +
             91,080/(1.12)3 – 165,000 = 12,627.42
        Using the calculator:
           § CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =
             70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV;
             I = 12; CPT NPV = 12,627.42
        Do we accept or reject the project?




BMGT440 – Dr. E F Kiss                                      -11
                         Decision Criteria Test - NPV

        Does the NPV rule account for the time
         value of money?
        Does the NPV rule account for the risk of
         the cash flows?
        Does the NPV rule provide an indication
         about the increase in value?
        Should we consider the NPV rule for our
         primary decision criteria?



BMGT440 – Dr. E F Kiss                                  -12
             Calculating NPVs with a Spreadsheet

        Spreadsheets are an excellent way to
         compute NPVs, especially when you have
         to compute the cash flows as well.
        Using the NPV function
           § The first component is the required return
             entered as a decimal
           § The second component is the range of cash
             flows beginning with year 1
           § Subtract the initial investment after
             computing the NPV

BMGT440 – Dr. E F Kiss                                    -13
                         Payback Period

        How long does it take to get the initial cost
         back in a nominal sense?
        Computation
           § Estimate the cash flows
           § Subtract the future cash flows from the
             initial cost until the initial investment has
             been recovered
        Decision Rule – Accept if the payback period
         is less than some preset limit


BMGT440 – Dr. E F Kiss                                       -14
              Computing Payback For The Project

        Assume we will accept the project if it pays
         back within two years.
           § Year 1: 165,000 – 63,120 = 101,880 still to
             recover
           § Year 2: 101,880 – 70,800 = 31,080 still to
             recover
           § Year 3: 31,080 – 91,080 = -60,000 project
             pays back in year 3
        Do we accept or reject the project?


BMGT440 – Dr. E F Kiss                                     -15
                  Decision Criteria Test - Payback

        Does the payback rule account for the time
         value of money?
        Does the payback rule account for the risk
         of the cash flows?
        Does the payback rule provide an
         indication about the increase in value?
        Should we consider the payback rule for
         our primary decision criteria?



BMGT440 – Dr. E F Kiss                                -16
              Advantages and Disadvantages of Payback

        Advantages                    Disadvantages
           § Easy to understand         § Ignores the time
           § Adjusts for                  value of money
             uncertainty of later       § Requires an arbitrary
             cash flows                   cutoff point
           § Biased towards             § Ignores cash flows
             liquidity                    beyond the cutoff
                                          date
                                        § Biased against long-
                                          term projects, such
                                          as research and
                                          development, and
                                          new projects

BMGT440 – Dr. E F Kiss                                            -17
                         Discounted Payback Period

        Compute the present value of each cash
         flow and then determine how long it takes
         to payback on a discounted basis
        Compare to a specified required period
        Decision Rule - Accept the project if it pays
         back on a discounted basis within the
         specified time




BMGT440 – Dr. E F Kiss                                   -18
             Computing Discounted Payback for the Project
      Assume we will accept the project if it pays
       back on a discounted basis in 2 years.
      Compute the PV for each cash flow and
       determine the payback period using
       discounted cash flows
        §   Year 1: 165,000 – 63,120/1.121
        §   165,000 – 56,357.14 = 108,643
        §   Year 2: 108,643 – 70,800/1.122
        §   108,643 – 56,441.33 = 52,202
        §   Year 3: 52,202 – 91,080/1.123
        §   52,202 – 64,828.94 = -12,627 project pays back
            in year 3
      Do we accept or reject the project?
BMGT440 – Dr. E F Kiss                                       -19
            Decision Criteria Test – Discounted Payback

        Does the discounted payback rule account
         for the time value of money?
        Does the discounted payback rule account
         for the risk of the cash flows?
        Does the discounted payback rule provide
         an indication about the increase in value?
        Should we consider the discounted
         payback rule for our primary decision
         criteria?


BMGT440 – Dr. E F Kiss                                    -20
             Advantages and Disadvantages of Discounted Payback

        Advantages                   Disadvantages
           § Includes time value       § May reject positive
             of money                    NPV investments
           § Easy to understand        § Requires an arbitrary
           § Does not accept             cutoff point
             negative estimated        § Ignores cash flows
             NPV investments             beyond the cutoff
           § Biased towards              point
             liquidity                 § Biased against long-
                                         term projects, such
                                         as R&D and new
                                         products


BMGT440 – Dr. E F Kiss                                           -21
                         Average Accounting Return

        There are many different definitions for
         average accounting return
        The one used in the book is:
           § Average net income / average book value
           § Note that the average book value depends
             on how the asset is depreciated.
        Need to have a target cutoff rate
        Decision Rule: Accept the project if the AAR
         is greater than a preset rate.



BMGT440 – Dr. E F Kiss                                  -22
                  Computing AAR For The Project

        Assume we require an average accounting
         return of 25%
        Average Net Income:
           § (13,620 + 3,300 + 29,100) / 3 = 15,340
        AAR = 15,340 / 72,000 = .213 = 21.3%
        Do we accept or reject the project?




BMGT440 – Dr. E F Kiss                                -23
                         Decision Criteria Test - AAR

        Does the AAR rule account for the time
         value of money?
        Does the AAR rule account for the risk of
         the cash flows?
        Does the AAR rule provide an indication
         about the increase in value?
        Should we consider the AAR rule for our
         primary decision criteria?



BMGT440 – Dr. E F Kiss                                  -24
           Advantages and Disadvantages of AAR

        Advantages                  Disadvantages
           § Easy to calculate        § Not a true rate of
           § Needed information         return; time value of
             will usually be            money is ignored
             available                § Uses an arbitrary
                                        benchmark cutoff
                                        rate
                                      § Based on accounting
                                        net income and book
                                        values, not cash
                                        flows and market
                                        values


BMGT440 – Dr. E F Kiss                                          -25
                         Internal Rate of Return

        This is the most important alternative to
         NPV
        It is often used in practice and is intuitively
         appealing
        It is based entirely on the estimated cash
         flows and is independent of interest rates
         found elsewhere




BMGT440 – Dr. E F Kiss                                     -26
                IRR – Definition and Decision Rule
        Definition: IRR is the return that makes the NPV = 0
        Decision Rule: Accept the project if the IRR is greater
         than the required return
        NPV: Enter R, solve for NPV.

                     n
                          CFt
                      1  R t  NPV .
                     t 0

      IRR: Enter NPV = 0, solve for IRR.

               n
                         CFt
             t 0   1  IRR t
                                  0.



BMGT440 – Dr. E F Kiss                                             -27
                   Computing IRR For The Project

        If you do not have a financial calculator,
         then this becomes a trial and error process
        Calculator
           § Enter the cash flows as you did with NPV
           § Press IRR and then CPT
           § IRR = 16.13% > 12% required return
        Do we accept or reject the project?




BMGT440 – Dr. E F Kiss                                  -28
                         NPV Profile For The Project

             70,000
             60,000
                                                IRR = 16.13%
             50,000
             40,000
             30,000
       NPV




             20,000
             10,000
                  0
             -10,000 0   0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

             -20,000
                                          Discount Rate


BMGT440 – Dr. E F Kiss                                                          -29
                         Decision Criteria Test - IRR

        Does the IRR rule account for the time
         value of money?
        Does the IRR rule account for the risk of
         the cash flows?
        Does the IRR rule provide an indication
         about the increase in value?
        Should we consider the IRR rule for our
         primary decision criteria?



BMGT440 – Dr. E F Kiss                                  -30
                         Advantages of IRR

        Knowing a return is intuitively appealing
        It is a simple way to communicate the
         value of a project to someone who does
         not know all the estimation details
        If the IRR is high enough, you may not
         need to estimate a required return, which
         is often a difficult task




BMGT440 – Dr. E F Kiss                               -31
            Summary of Decisions For The Project

     Summary

     Net Present Value               Accept

     Payback Period                  Reject

     Discounted Payback Period       Reject

     Average Accounting Return       Reject

     Internal Rate of Return         Accept

BMGT440 – Dr. E F Kiss                             -32
             Calculating IRRs With A Spreadsheet

        You start with the cash flows the same as
         you did for the NPV
        You use the IRR function
           § You first enter your range of cash flows,
             beginning with the initial cash flow
           § You can enter a guess, but it is not
             necessary
           § The default format is a whole percent – you
             will normally want to increase the decimal
             places to at least two

BMGT440 – Dr. E F Kiss                                     -33
                             NPV Vs. IRR

        NPV and IRR will generally give us the
         same decision
        Exceptions
           § Non-conventional cash flows – cash flow
             signs change more than once
           § Mutually exclusive projects
                Initial investments are substantially different
                Timing of cash flows is substantially
                 different



BMGT440 – Dr. E F Kiss                                             -34
            IRR and Non-conventional Cash Flows

        When the cash flows change sign more
         than once, there is more than one IRR
        When you solve for IRR you are solving for
         the root of an equation and when you
         cross the x-axis more than once, there will
         be more than one return that solves the
         equation
        If you have more than one IRR, which one
         do you use to make your decision?


BMGT440 – Dr. E F Kiss                                 -35
              Another Example – Non-conventional Cash Flows

        Suppose an investment will cost $90,000
         initially and will generate the following
         cash flows:
           § Year 1: 132,000
           § Year 2: 100,000
           § Year 3: -150,000
        The required return is 15%.
        Should we accept or reject the project?



BMGT440 – Dr. E F Kiss                                        -36
                                       NPV Profile
                                        IRR = 10.11% and 42.66%
              $4,000.00

              $2,000.00

                   $0.00
                            0   0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
              ($2,000.00)
       NPV




              ($4,000.00)

              ($6,000.00)

              ($8,000.00)

             ($10,000.00)
                                                Discount Rate


BMGT440 – Dr. E F Kiss                                                              -37
                         Summary of Decision Rules

        The NPV is positive at a required return of
         15%, so you should Accept
        If you use the financial calculator, you
         would get an IRR of 10.11% which would
         tell you to Reject
        You need to recognize that there are non-
         conventional cash flows and look at the
         NPV profile




BMGT440 – Dr. E F Kiss                                 -38
              IRR and Mutually Exclusive Projects
        Mutually exclusive projects
           § If you choose one, you can’t choose the
             other
           § Example: You can choose to attend
             graduate school next year at either Harvard
             or Stanford, but not both
        Intuitively you would use the following
         decision rules:
           § NPV – choose the project with the higher
             NPV
           § IRR – choose the project with the higher
             IRR
BMGT440 – Dr. E F Kiss                                     -39
              Example With Mutually Exclusive Projects

     Period              Project A Project   The required return
                                   B         for both projects is
                                             10%.
     0                   -500      -400

     1                   325       325
                                             Which project
     2                   325       200
                                             should you accept
                                             and why?
     IRR                 19.43%    22.17%

     NPV                 64.05     60.74
BMGT440 – Dr. E F Kiss                                              -40
                                 NPV Profiles

             $160.00
                                          IRR for A = 19.43%
             $140.00
             $120.00                      IRR for B = 22.17%
             $100.00
                                          Crossover Point = 11.8%
              $80.00
       NPV




                                                                           A
              $60.00
                                                                           B
              $40.00
              $20.00
               $0.00
             ($20.00) 0   0.05    0.1       0.15        0.2   0.25   0.3
             ($40.00)
                                        Discount Rate


BMGT440 – Dr. E F Kiss                                                         -41
                  Conflicts Between NPV and IRR

        NPV directly measures the increase in
         value to the firm
        Whenever there is a conflict between NPV
         and another decision rule, you should
         always use NPV
        IRR is unreliable in the following situations
           § Non-conventional cash flows
           § Mutually exclusive projects




BMGT440 – Dr. E F Kiss                                   -42
                         Profitability Index

        Measures the benefit per unit cost, based
         on the time value of money
        A profitability index of 1.1 implies that for
         every $1 of investment, we create an
         additional $0.10 in value
        This measure can be very useful in
         situations where we have limited capital




BMGT440 – Dr. E F Kiss                                   -43
           Advantages and Disadvantages of Profitability Index

        Advantages                    Disadvantages
           § Closely related to         § May lead to incorrect
             NPV, generally               decisions in
             leading to identical         comparisons of
             decisions                    mutually exclusive
           § Easy to understand           investments
             and communicate
           § May be useful when
             available investment
             funds are limited




BMGT440 – Dr. E F Kiss                                            -44
                               More examples

                         What is the payback period?



                 The expected number of years required
                 to recover a project’s cost,

                 or how long does it take to
                 get our money back?
                 calculate payback by developing the cumulative CF
                 as shown on next slide for project L

                 Our examples use projects L (long) and S (short)
BMGT440 – Dr. E F Kiss                                               -45
                        Payback for Project L
                    (Long: Most CFs in out years)


                          0          1             2    2.4   3


      CFt                -100        10           60          80
                                                        .
      Cumulative -100               -90           -30   0     50

       PaybackL = 2             +         30/80     = 2.375 years



BMGT440 – Dr. E F Kiss                                              -46
               Project S (Short: CFs come quickly)

                          0      1    1.6    2       3


                         -100   70    .     50       20
      CFt
      Cumulative -100           -30   0     20       40

       PaybackL = 1 + 30/50 = 1.6 years



BMGT440 – Dr. E F Kiss                                    -47
        C. 3. Discounted Payback:
        Uses discounted rather than raw CFs.

                             0              1        2      3
                                     10%

      CFt                -100              10       60      80

      PVCFt              -100              9.09   49.59    60.11

      Cumulative -100                  -90.91     -41.32   18.79

      Disc.              =       2     + 41.32/60.11 = 2.687 yrs
      payback
                Recover investment + cap costs in 2.7 yrs.
BMGT440 – Dr. E F Kiss                                             -48
 NPV: Sum of the PVs of inflows and outflows.


                                  n
                                      CFt
                         NPV               .
                               t 0   R 
                                           t
                                     1


                  Cost often is CF0 and is negative.
                                      n
                                       CFt
                          NPV                CF0 .
                                t 1   R 
                                            t
                                      1


BMGT440 – Dr. E F Kiss                                  -49
                         What’s Project L’s NPV?

       Project L:
                 0                1         2           3
                           10%


              -100.00            10        60           80

                 9.09
                49.59
                60.11
              $18.79 = NPVL            NPVS = $19.98.
BMGT440 – Dr. E F Kiss                                       -50
                         Calculator Solution:


             Enter in CFLO for L:

               -100      CF0

                  10     CF1

                  60     CF2

                  80     CF3
                  10      I     NPV     = $18.78 = NPVL
BMGT440 – Dr. E F Kiss                                    -51
                     Rationale for the NPV Method


                  NPV = PV inflows - Cost
                      = Net gain in wealth.
                  For independent projects,
                  Accept project if NPV > 0.

                  Choose between mutually
                  exclusive projects on basis of
                  higher NPV. Choose the one that adds the
                  most value.
BMGT440 – Dr. E F Kiss                                       -52
        Using NPV method, which project(s) should
                     be accepted?
                        If Projects S and L are
                         mutually exclusive, accept S
                         because NPVs > NPVL .

                        If S & L are independent,
                         accept both; NPV > 0.




BMGT440 – Dr. E F Kiss                                  -53
            Would the NPVs change if the cost of capital
                           changed?

      The NPV of a project is dependent on the
       cost of capital used.
      if the cost of capital changed, the NPV of
       each project would change.
      NPV declines as R increases and NPV
       rises as R falls




BMGT440 – Dr. E F Kiss                                     -54
                         Internal Rate of Return: IRR


          0                   1             2            3

        CF0                  CF1          CF2           CF3
       Cost                             Inflows

               IRR is the discount rate that forces
               PV inflows = cost.
               This is the same as forcing NPV = 0.


BMGT440 – Dr. E F Kiss                                        -55
          NPV: Enter R, solve for NPV.
                   n
                     CFt
                 1  R t  NPV .
                t 0


          IRR: Enter NPV = 0, solve for IRR.
                          n
                               CFt
                          1  IRR t  0.
                         t 0



BMGT440 – Dr. E F Kiss                         -56
                         What’s Project L’s IRR?

          0                  1           2             3
                   IRR = ?

      -100.00                10         60             80
        PV1
         PV2
         PV3
       0 = NPV           Enter CFs in CFLO, then
                         press, IRR:

            IRRL = 18.13%.            IRRS = 23.56%.
BMGT440 – Dr. E F Kiss                                      -57
         Find IRR if Cash Flows are constant:
          0                      1                  2               3
                IRR = ?

       -100                      40                 40              40
    INPUTS
                         3                   -100        40    0
                             N        I/YR     PV        PMT   FV
  OUTPUT
  OUTPUT                         9.70%

          Or, with CFLO, enter CFs and press
          IRR = 9.70%.

BMGT440 – Dr. E F Kiss                                                   -58
                     How is a project’s IRR
                     related to a bond’s YTM?
                     They are the same thing.
                     A bond’s YTM is the IRR
                     if you invest in the bond.

          0                 1           2         10
                IRR = ?

      -1134.2               90          90        1090

              IRR = 7.08% (use TVM or CFLO).

BMGT440 – Dr. E F Kiss                                   -59
                   . Rationale for the IRR method:


                     If IRR > WACC, then the
                     project’s rate of return is
                     greater than its cost
                     => some return is left over to
                      boost stockholders’ returns.

                     Example: WACC = 10%,
                     IRR = 15%. Profitable.

BMGT440 – Dr. E F Kiss                                -60
                             IRR acceptance criteria:



                            If IRR > R, accept project.

                            If IRR < R, reject project.




BMGT440 – Dr. E F Kiss                                     -61
        Decisions on our Projects S and L per IRR:


                If S and L are independent, accept
                 both. IRRs > R = 10%.

                If S and L are mutually exclusive,
                 accept S because IRRS > IRRL .




BMGT440 – Dr. E F Kiss                                -62
      would the projects’ IRRs change if the cost of capital
                            changed?



         IRRs are independent of the cost of capital
         therefore, neither IRR s nor IRR L would
          change if R changed
         however, the acceptability of the projects
          could change
           § L would be rejected if R were above 18.1%
           § S would also be rejected if R were > 23.6%



BMGT440 – Dr. E F Kiss                                         -63
                  Reinvestment Rate Assumptions

               NPV assumes reinvest at R (opportunity
                cost of capital).
               IRR assumes reinvest at IRR.
               Reinvest at opportunity cost, R, is more
                realistic, so NPV method is best. NPV
                should be used to choose between
                mutually exclusive projects.



BMGT440 – Dr. E F Kiss                                     -64
           Managers like rates--prefer IRR to NPV
          comparisons. Can we give them a better
                           IRR?

       Yes, MIRR is the discount rate which
       causes the PV of a project’s terminal
       value (TV) to equal the PV of costs.
       TV is found by compounding inflows
       at WACC.

       Thus, MIRR assumes cash inflows
       are reinvested at WACC.

BMGT440 – Dr. E F Kiss                              -65
         MIRR for Project L (R = 10%):
         0                        1                     2                        3
                 10%


        -100.0                 10.0                  60.0                       80.0

                                                            10%                 66.0
   PV outflows                            10%
                                                                                12.1
                                  MIRR =
                                                                             158.1
         -100.0                   16.5%
                                                                           TV inflows
                                  $100 =             $158.1
                                                   (1+MIRRL)3

        = 16.5%;
MIRRL – Dr. E F Kiss
BMGT440
                            in table A-3: 1.581 = 158.1/100
                       LookFin 103 - Chapter 10 - Dr. Elinda Fishman Kiss= PMT; find R when N=3
                                                                                             -66
         To find TV with HP10B, enter in CFLO:
         CF0 = 0, CF1 = 10 , CF2 = 60, CF3 = 80
          i = 10
          NPV = 118.78 = PV of inflows.
         EnterPV = -188.78, N = 3, i = 10, PMT = 0.

         Press FV = 158.10 = FV of inflows.

         Enter FV = 158.10, PV = -100, PMT = 0, N = 3.

         Press i = 16.50% = MIRR.
BMGT440 – Dr. E F Kiss                                   -67
                         Why use MIRR versus IRR?


            MIRR correctly assumes
            reinvestment at opportunity cost =
            WACC. MIRR also avoids
            the problem of multiple
            IRRs.
            Managers like rate of return
            comparisons, and MIRR is
            better for this than IRR.
BMGT440 – Dr. E F Kiss                              -68
                         Define Profitability Index



                                   n
                            CIFt
                       1  R t
                       t 0
                  PI  n          .
                            COFt
                       1  R t
                       t 0


BMGT440 – Dr. E F Kiss                                -69
                         What is each franchise’s PI?


                $9.09  $49.59  $60.11
         PI L 
                         $100
               1.1879  1.19.

         PIS  ($63.636  $41.32  $15.03) / $100 
  1.1998  1.20.
                 Accept project if PI > 1.0.
BMGT440 – Dr. E F Kiss                                  -70
                     Capital Budgeting In Practice

        We should consider several investment
         criteria when making decisions
        NPV and IRR are the most commonly used
         primary investment criteria
        Payback is a commonly used secondary
         investment criteria




BMGT440 – Dr. E F Kiss                               -71
              Summary – Discounted Cash Flow Criteria
   Net present value
      § Difference between market value and cost
      § Take the project if the NPV is positive
      § Has no serious problems
      § Preferred decision criterion
   Internal rate of return
      § Discount rate that makes NPV = 0
      § Take the project if the IRR is greater than required
          return
      § Same decision as NPV with conventional cash flows
      § IRR is unreliable with non-conventional cash flows or
          mutually exclusive projects
   Profitability Index
      § Benefit-cost ratio
      § Take investment if PI > 1
      § Cannot be used to rank mutually exclusive projects
      § May be use to rank projects in the presence of capital
BMGT440 – rationing
          Dr. E F Kiss                                           -72
                         Summary – Payback Criteria
     Payback period
       § Length of time until initial investment is
         recovered
       § Take the project if it pays back in some specified
         period
       § Doesn’t account for time value of money and
         there is an arbitrary cutoff period
     Discounted payback period
       § Length of time until initial investment is
         recovered on a discounted basis
       § Take the project if it pays back in some specified
         period
       § There is an arbitrary cutoff period
BMGT440 – Dr. E F Kiss                                    -73
                 Summary – Accounting Criterion
       Average Accounting Return
         § Measure of accounting profit relative to book
           value
         § Similar to return on assets measure
         § Take the investment if the AAR exceeds
           some specified return level
         § Serious problems and should not be used




BMGT440 – Dr. E F Kiss                                     -74
                     Quick Quiz
    Consider an investment that costs $100,000
     and has a cash inflow of $25,000 every year
     for 5 years. The required return is 9% and
     required payback is 4 years.
      § What is the payback period?
      § What is the discounted payback period?
      § What is the NPV?
      § What is the IRR?
      § What is the MIRR?
      § What is the PI?
      § Should we accept the project?
   What decision rule should be the primary
     decision method?
   When is
BMGT440 – Dr. E F Kiss the IRR rule unreliable?    -75

				
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Description: Solutions to Net Present Value and Other Investment Criteria document sample